Skip to main content

A group of high-profile hedge fund managers came to Washington, D.C. Thursday, acknowledging that

stricter oversight

of their unregulated industry is certainly on its way, but warning that overregulation could be just as destructive.

Hedge funds have gotten plenty of negative attention this year for exacerbating the financial meltdown. First, they were blamed for causing the demise of struggling financial institutions by betting against the share prices of companies like

Lehman Brothers


Freddie Mac

( FRE),

Fannie Mae

( FNM),


(AIG) - Get American International Group Inc. Report


Washington Mutual



Scroll to Continue

TheStreet Recommends

(WB) - Get Weibo Corporation Report


But the tides soon turned, as the market left few


or other investments unpunished, and

hedge funds

started buckling under the weight of the economic downturn. Over the past two months, many funds have been forced to liquidate holdings to meet redemptions, fueling volatility and the market's steep declines.

Broadly speaking, the industry posted a 16% downturn in the third quarter alone, according to data provider That left hedge funds with $2.5 trillion, which is then leveraged perhaps fivefold in terms of assets. Performance losses accounted for $347.5 billion, as investors redeemed $117.3 billion and funds liquidated a net $10.9 billion of their positions. Before the House Committee on Oversight and Government Reform on Thursday, George Soros, chairman, Soros Fund Management, predicted that ultimately, the amount of money hedge funds manage will shrink 50% to 75%.

"It has to be recognized that hedge funds were also an integral part of the bubble," says Soros, "which now has burst."

Henry Waxman, chairman of the committee, said on Thursday that regulators are taking a closer look at the industry to determine the role hedge funds have played in the financial meltdown, and how they ought to be regulated going forward. He noted that hedge funds are "virtually unregulated," and that the government cannot say with certainty how many exist or how much money they manage.

Several suggestions have been floated about how to deal with hedge funds, which compete fiercely for wealthy clients and guard strategies closely to retain a competitive advantage. Funds tend to boost returns by using a huge amount of leverage, which could make the pain of a fault bet substantially worse.

Regulators are taking a closer look at both of those elements, as well as top-level compensation and tax policy of hedge-fund managers. Some portion of managers' salary is only required to pay a capital gains tax of 15%, when the tax level for wealthy individuals' earnings is much higher.

"That's a lower tax rate than many school teachers, firefighters, or plumbers pay," Waxman noted.

Regulators have also begun to crack down on short-selling, by requiring funds to disclose their short positions, banning "naked" short selling and putting a hold on short positions for a list of battered companies. The

Securities and Exchange Commission

is also investigating whether illegal rumor mongering occurred to drive down certain stocks further.

Another issue that has rocked the markets is the murky world of derivatives. Kenneth Griffin, president and CEO of Citadel Investment Group threw his support behind the notion of a central clearinghouse to sort through and guarantee such opaque assets, like

credit-default swaps

, which have wreaked havoc at several large institutions, and nearly caused the demise of AIG. Griffin called it one potential "straightforward solution" to the issue of systemic risk.

Soros and Griffin were joined by three other prominent hedge-fund leaders to testify, each of whom earned an average of $1 billion or more last year. The others were John Paulson, president of Paulson & Co.; James Simons, president of Renaissance Technologies; and Philip Falcone, senior managing partner of Harbinger Capital Partners.

While each discussed different aspects of the financial crisis and made different suggestions of how to deal with it, their resounding collective message seemed to be: We didn't start the fire, so please don't throw us onto the pit.

Falcone noted that while he has done "extremely well financially," his success is tied to the fund's performance, and investors are "fully aware of the compensation formula when deciding whether to place their money with us." Paulson, whose firm profited considerably by making bets against the housing market before the bubble burst, also noted that hedge funds provide wealthy investors with an opportunity to hold non-traditional assets that are managed in a sophisticated way.

Falcone also took to defending short selling, or bets that a stock will fall, asserting that such investments often shine light on troubled firms that pose a great risk to the market. After all, said Falcone, "it isn't short selling that puts companies out of business, but rather over-leveraged balance sheets, poor management decisions and flawed business plans."

It is unclear what tactics the next administration and new Congress may employ to tighten its regulatory reigns over the hedge-fund world. But the managers seemed to be outlining their own notions in an effort to, as Soros put it, "preempt a regulatory overkill."